Implementing governance reform

The massive financial overhaul bill recently signed into law by President Obama has been called the most sweeping set of financial reforms since the Great Depression. Comprising hundreds of pages, the Dodd-Frank Wall Street Reform and Consumer Protection Act is full of mandates that will keep public companies on their toes for months, if not years, to come.

While some of the act’s provisions take immediate effect, most will be phased in. A public company navigating this regulatory maze will need to determine not only which rules apply, but also when they will apply. Here we present some of the key topics that will affect public company practices, and provide some guidance on ways companies can begin preparing.

Parachutes and say on pay

The so-called say-on-pay component will require companies to give shareholders a chance to voice their approval on a public company’s disclosures of executive compensation. The law does not, however, require anything of firms if shareholders show displeasure.

Critics have pointed out that it will be unclear exactly what a ‘no’ vote would be opposing. Is it the specific disclosures, the lack of transparency about executive compensation, or the actual dollar amount of the compensation itself? Proponents argue, however, that the rule will encourage boards to consider shareholder opinions when making executive pay decisions.

These votes must be included in proxy statements for annual meetings from six months after the law’s signing (that is, starting in January 2011). Company boards should analyze their executive compensation packages now and revisit their disclosures with an eye to anticipating potentially controversial elements.

Similar voting rules will apply to golden parachute payments for executives in connection with mergers and acquisitions. Shareholders will get to approve or disapprove disclosures regarding these payments for senior executives, too. Companies looking toward potential M&A transactions may want to review employment, severance and other arrangements that could be triggered by a transaction to determine whether any potential golden parachute payments might cause discord among their
shareholder bases.

Influencing the way shareholders vote on say on pay will be newly required disclosures illustrating the relationship between executive compensation and company financial performance. The disclosure will take into account stock price and dividends and will likely include a graph showing the relationship between the two.

Companies will also be required to provide the ratio of their CEOs’ total compensation to median employee total compensation. Total compensation will be calculated under the same method as currently provided in proxy statements for executive officers. This will be a potentially daunting data-gathering exercise for
companies with many employees, so companies should begin formulating a process now to ensure they will be able to run the new calculations in good time.

Under the act, the SEC is required to instruct national securities exchanges such as the NYSE and NASDAQ to de-list companies that have not implemented and disclosed a clawback policy, which allows a company to take back any excess executive incentives and bonuses tied to restated financials. Large public companies that already have some form of clawback policy will need to review it for compliance with the more precise requirements outlined in the act. Firms without clawback policies should begin the drafting process now.

Proxy access

Under current rules, shareholders who want to nominate someone to serve on a board of directors must file their own proxy statements – at considerable expense. A growing shareholder democracy movement has long lobbied for investors to be able to nominate their own candidates without incurring the costs themselves.

Thanks to Dodd-Frank, the SEC has been given express authority to adopt rules relating to the inclusion of shareholders’ nominees in a company’s proxy materials. Although the SEC struggled over the last decade to find a balance between shareholder interests and boards of directors’ authority, following Dodd-Frank’s enactment, the commission moved swiftly. New rules to be effective later this fall will start allowing inclusion in company proxy materials of nominees by shareholders holding at least 3 percent who have held their shares for at least three years and meet certain other conditions.

In preparation, companies should analyze their shareholder bases and strive to maintain open dialogue with major holders. Healthy investor relations could go a long way toward allaying adverse shareholder activism.

Compensation committee independence

Similarly to the clawback reforms, Dodd-Frank will require national stock exchanges to de-list non-exempt companies whose compensation committees fail to meet certain heightened independence requirements. New independence rules – still to be developed by the SEC – will take into account consulting, advisory and other fees paid to compensation committee members, and also account for whether members are affiliates of the firm.

The new rules will mandate that compensation committees be authorized to retain and manage compensation consultants, legal counsel and other advisers only after evaluating their independence based on an array of ‘competitively neutral’ factors to be determined by the SEC, such as other services performed for the company, policies and procedures designed to prevent conflicts of interest, and business or personal relationships between the adviser and compensation committee members. The rules will also require a listed firm to disclose whether its compensation committee retained a compensation consultant, whether that retention raised any conflicts of interest,
and how any resulting conflicts are being addressed.

Disclosures relating to this rule will be required to be included in proxy statements issued after the act’s one-year anniversary, so most companies won’t be subject to the requirements until the 2012 proxy season. Changes in practices or committee members can require lengthy lead times, however, so listed companies should begin analyzing these issues sooner rather than later.

Disclosure of board leadership

Dodd-Frank stopped short of requiring companies to have separate chairman and CEO roles. Yet, under the act, the SEC must issue rules that will require public firms to discuss in their proxy statements their reasons for having separated or combined the two positions.

The drafters of Dodd-Frank were a couple of steps behind on this one, however. SEC rules that took effect during the 2010 proxy season already require the chairman-CEO leadership disclosures mandated by the act, so most public companies should already be familiar with – and in many cases have already provided – these disclosures.
Other new governance requirements cover internal control audit exemptions and various disclosures regarding topics such as hedging of company securities and reforms relating to public companies’ use of credit ratings.

Although it came at the end of a lengthy legislative process, the Dodd-Frank Act promises to mark the beginning of an extensive rule-making process. Public companies and market participants will be paying close attention as new regulations are proposed and implemented. While debate continues as to whether the act appropriately responds to the financial crisis that initially triggered the reforms, one thing is certain: public companies now face a new regulatory environment that will continue to evolve in the coming months.